The Ten Steps of Stagflation
Published March 7, 2023
America is experiencing a return of high inflation and uncertain economic growth. This could signal stagflation and a return to the economic woes of the 1970s. Regardless, the best cure for inflation or stagflation is prevention. This requires the Federal Reserve to make the hard call of raising interest rates early at the first sign of inflation.
- Do you think stagflation is a serious danger in the future? Why or why not?
- Who is hurt the most by stagflation? Does anyone benefit?
America is experiencing a return of high inflation and uncertain economic growth.
Some worry that we may be entering a period of stagflation like in the 1970s, when inflation was routinely above 10 percent and unemployment rates were double what they are today.
How can we tell if stagflation is coming? It turns out that there is a predictable historical pattern.
Step one is inflation shock. Too much federal spending, artificial restrictions or a shock to the supply chain, plus a slow-moving Federal Reserve all lead to increased costs for businesses and soaring prices for consumers.
At this point, prices rise faster than wages, so workers can't afford as much as they could before.
This leads to lower consumption, since workers have less to spend.
Since consumption is the lion’s share of GDP, less consumption leads to lower economic growth - or no growth at all.
During this stage when prices are rising but wages are not, businesses don't need to lay off employees yet. But fewer people spending money on goods and services, plus the same number of people working, equals a collapse in productivity and profitability.
Next, the Federal Reserve finally catches up to the fact that inflation has arrived and growth is slowing. To make up for lost time, it has to hike interest rates aggressively, and probably repeatedly.
Before long, workers demand wage increases to keep up with the price of inflation, which means steep increases to labor costs for businesses.
Higher interest rates slow down economic growth even further, by slowing down business investments and making it more expensive to buy a house. This is when the economy nosedives, and if growth becomes negative, we end up in a recession.
Eventually, the sustained decline in demand puts downward pressure on price inflation, lowering it to the level of wage inflation.
While this downward pressure provides some cost relief for businesses, it's rarely enough to offset the previous cost and wage increases.
As the Federal Reserve continues to raise interest rates to cut inflation, firms that can’t hold wages down or otherwise cut costs must layoff workers.
And once the Federal Reserve gets interest rates above inflation, layoffs begin for firms that can't hold wages down or cut costs otherwise, and unemployment climbs.
Finally, when prices and wages fall sufficiently, the recession ends, and inflation (hopefully) gets back under control.
As with inflation, the best cure for stagflation is prevention. This requires the Fed to keep spending under control, and to make the hard call to raise rates early - the next time inflation is on the horizon.